Money funds in a tight spot as yields decline

Published 10:00 pm, Friday, October 11, 2002

Rarely have so many earned so little from so much.

That's the strange new plot line unfolding in one of the modern world's great financial success stories, money-market mutual funds.

In a short 30 years after the first of the breed, the Reserve Fund, appeared on the scene in 1971, money funds blossomed into a $2.2 trillion business, displacing traditional bank passbook savings accounts. They brought investors -- 45 million of them at last count -- better short-term returns than most banks offer, in a package that gained a reputation for safety and convenience. Big institutions like them too.

Now this sunny scene is clouded by a decline in interest rates that has gone further and lasted longer than anybody expected. "We're predicting the first year since 1983 that money funds will see a decline in assets," says Peter Crane, managing editor at money-fund tracker iMoneyNet Inc. in Westborough, Mass.

Yields on money funds started tumbling almost two years ago from more than 6 percent as the Federal Reserve cut short-term interest rates. When the returns passed 5 percent, 4 percent, 3 percent and even 2 percent, nobody seemed to mind much. In 2001, according to the Investment Company Institute, a record $376 billion poured in from investors, pushing the total in the pot past $2 trillion only four years after it broke $1 trillion.

As yields kept dropping this year, the tide reversed. Now, with the latest average yield reported by iMoneyNet at 1.25 percent (1.08 percent for funds specializing in tax-exempt municipal securities), ICI data show a $95 billion outflow for the first eight months of 2002.

From individual investors' point of view, the situation shapes up more as a curiosity than a crisis. You or I are unlikely to lose any money at the hands of "negative yields," nor do we ever have to stand for such a thing. It's a simple act to write a check cashing out of a money fund.

So as a practical matter no money fund that hopes to stay in business for long can afford to start charging a negative yield against its investors' accounts, even if the interest it earns on its investments falls below the cost of expenses and fees.

What next?

A few managers have already begun waiving fees they charge their funds, Crane says, in order to avoid reporting zero or negative yields.

And what if the Fed should cut money rates again from the prevailing level of 1.75 percent for overnight loans between banks, as some think it soon might? "That would hurt," said Crane.

In what he describes as a "low margin" business, it's already getting harder for managers to operate money funds profitably. According to Crane, of the approximately 180 fund firms that operate money funds, about half have assets in that category of $1 billion or less.

Over time this could become a setup for what analysts like to call "consolidation," with less-successful operators closing up shop or merging into larger ones. "The larger players probably get larger, and the smaller players go away," says Debbie Cunningham, who oversees $130 billion in taxable money funds at Federated Investors Inc. in Pittsburgh.

Stock- and bond-fund specialists also have the option of "outsourcing" their money-fund businesses, hiring outside managers while keeping the name and the marketing responsibilities for themselves.

Aside from incredible shrinking yields, what does this mean for individual investors? I repeat, there's no crisis at hand. Still, if yields are negligible, the temptation increases to move money back into bank accounts that, unlike money funds, are insured by the federal government.

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Bent's firm now offers the alternative of an account that channels money into federally insured deposits. Several big brokerage houses have experimented with shifting their daily sweeps of customers' idle funds into bank deposits rather than money funds.

It bears remembering that money funds have done great things on investors' behalf. Crane figures they brought us something like $250 billion more in yield than we would have earned over the past three decades had they never been invented. In a world of microscopic interest rates, though, their ability to keep working such wonders looks to be severely compromised.